Finding Undervalued Stocks – The Graham's Number Technique

Benjamin Graham (1894-1976) is considered by many to be the architect of Fundamental Analysis and Value Investing. Graham liked to find discrepancies between a stock’s price and its value and would buy large portfolios of undervalued stocks, holding them until they became fully valued. In his 1949 book “The Intelligent Investor, Graham describes a stock selection technique that identifies stocks that are trading at a deep discount to a calculated value termed the Net Current Asset Value or NCAV. Calculation of a stock’s NCAV is a fairly simple endeavor and is somewhat different from the calculation of Book Value. Whereas Book Value is purely a per share measure of Assets – Liabilities, the NCAV is a little more rigorous. In calculating NCAV, Graham only considered Current Assets, i.e. cash, cash equivalents, accounts receivable, inventories. However, from this value he still subtracted Total Liabilities. The result would then be divided by the number of shares outstanding to give the NCAV per share. This value would be considered by Graham to be a fair value for the stock.You might think he would buy at this price, but no. In most cases, Graham only bought stocks that were trading under two-thirds or 66% of their NCAV.Consider as an example G-III Apparel Group Ltd, ticker symbol GIII.Current Assets are $130.25M, Total Liabilities are $68.3M, and there are 7.22M shares outstanding.NCAV = (130.25 – 68.3) / 7.22 = $8.58. Two-thirds of this price would be $5.66.At the time of writing (03/07/05), GIII is trading at $7.67, so may not be a buy candidate at present.It is important to note that Graham would consider the NCAV to be a first step in further analysis of the stock. A sensible investor would investigate the balance sheet further to check for a sound business with other desirable factors such as good earnings, revenue growth, low debt-to-equity, and good operational cash flow per share. Stocks trading at such a deep discount are few and far between, and have usually been beaten down by a combination of bad news and emotional reactions from the investing public. These stocks were Graham’s bread and butter. He repeatedly insisted that the time to buy stocks was when everyone else was selling and the time to sell was when everyone else was buying. Had he been alive, he certainly would have been out of stocks before the dot com bubble burst and would surely have been picking up bargains soon after. It is no secret that one of Graham’s most famous disciples is Warren Buffett who has consistently beaten the market by a large margin with his investments. One study has shown that Graham’s NCAV strategy works well; in this particular study, portfolios picked using the strategy at the beginning of each year between 1970 and 1983 would have returned an average annual gain of over 29% when held for only the duration of each year in this 13 year period. Van Tharp mentions an actual investing strategy based on the NCAV or Graham’s Number as it is sometimes called, in his book “Safe Strategies for Financial Freedom”. The strategy as mentioned by Tharp involves buying stocks at two-thirds of their NCAV, and selling a third of your holding when a 50% profit is achieved. If the price continues upwards to 100% profit, you sell a number of shares to make up half your original holding. You now have your original investment back and have a holding of “free” shares. This strategy can be performed in an IRA using a large portfolio of perhaps 30 similarly undervalued stocks. If the market has been declining for several months, there will be several such stocks to choose from. In an up trending market, however, it will be much harder to find good value candidates but diligent investors who do their homework will more often than not be well rewarded for their efforts. Such a wide diversification may seem excessive for most investors, butwith such low-priced stock there were evidently going to be a few bankruptcycandidates. Graham considered this strategy to be suitable for what he called “defensive” investors. He did acknowledge, however, that there were some”enterprising” investors who could afford to be more aggressive from the pointof view of risk. To this end, he suggested a series of less onerous criteriafor selecting stocks which is outlined below.First, list all stocks with Price/Earnings ratios below 9. Note: Graham was writing in 1970 when P/E’s as a whole were not as elevated by technology stocks as they are today. Readers who are less risk-averse or who just want to consider a wider range of stocks may wish to vary the P/E in order to see what comes up — perhaps up to 80 percent of the average P/E of the S&P 500 would be a good start. Currently the operating average is around 18 and 85 percent of that figure is just over 15. Graham did not state if he was using a Trailing or Forward P/E ratio, but most likely he was using Trailing P/Es. I personally prefer to use Forward P/E ratios, especially if they are significantly lower than the Trailing P/E as this implies expected earnings growth and therefore possible increase in the stock price.Once we have a list of stocks meeting the P/E criterion, we consider the financialcondition of each stock, referring to the most recent balance sheet:Initially, Current Assets must be at least 1.5 times Current Liabilities. This can also be gleaned via a stock screener by displaying stocks with “Current Ratio” >= 1.5. Total Debt must not be greater than 110% of Net Current Assets (i.e. the sum of Cash & Cash Equivalents, Inventory, Accounts Receivable).Looking further back, we need to find evidence of Earnings Stability, with nodeficit in the last five years, i.e. no evidence of an annual loss. Additionally,evidence of earnings growth over a five-year period is a must. This can simplybe the consideration, for example, that 2004 earnings were greater than 2000 earnings.There should be some current dividend payout. Finally, the current price of thestock should be less than 120% of the NCAV per share or Graham’s Number.Where to find this number? From the balance sheet, subtract Total Liabilitiesfrom Current Assets, and divide the result by the number of shares outstanding.Assuming you have a positive number that is greater than zero, the stock’s priceshould not be greater than 120% of this number.

Graham did not set any lower limit on market capitalization. “Small companiesmay afford enough safety if bought carefully and on a group basis.” He meantthat a well diversified portfolio with a fair number of such companies stock would protect the enterprising investor from the bankruptcy of one or two companies